More Woe

The pound is this morning’s key story in the FX markets as it has ceded more than a penny in the London session. The driver appears to be news that forty MP’s have signed a letter indicating a lack of confidence in PM May’s ability to manage the Brexit talks. At the same time, the Labour Party has added to pressure on May by publishing their own letter indicating that they will support transition period legislation even though many Tories may not. The upshot is that May looks weaker than ever and concerns are growing that there may be yet another leadership election in the offing. And we cannot ignore the letter from two of May’s cabinet members, Brexit hawks Boris Johnson and Michael Gove, that is pushing for a clean break from the EU with no payments. All of this intrigue has weighed on the pound and will continue to do so. Arguably, if the UK does not develop a clearer idea of what they are willing to offer in this negotiation during the next month then the odds of a hard Brexit are going to increase substantially. Remember, too, that the UK economy is already the laggard in Europe. They can ill afford a process that adds to future uncertainty and thus reduces growth further. I have maintained that the pound has further to fall as the Brexit process develops and this morning’s news merely cements that view. Even though the pound is down today, I continue to be an advocate of hedging future receivables. The forward points remain favorable and it is very easy for me to foresee the pound back near 1.20 in twelve month’s time.

But while the pound has been the worst performer overnight, the dollar has rallied against eight of its G10 brethren with only the two haven currencies, CHF and JPY, showing strength. To my eyes, the evidence is slowly building that risk is falling into disfavor. Last week was the first since September that equity markets faltered, albeit slightly. Stories from the US continue to question exactly what will be in the tax reform legislation, which has clearly been an important support for the equity market. The yield curve continues to flatten as the Fed remains on track to raise rates in December, and arguably at least two more times next year. High yield securities continue to tumble with concerns over rising US rates and the historically low spread over investment grade securities beginning to frighten off investors. It just seems to me that when you add it all up, a long-overdue correction may well be in the offing. Lately I have been writing that the euro has become a safe haven in lieu of the dollar, at least relative to other G10 currencies, but perhaps the reality is a bit more nuanced. While the euro is likely to hold its own against the dollar, I still believe that the commodity and Scandinavian currencies will suffer more significantly. And EMG currencies will all falter on a risk-off move.

Speaking of EMG currencies, it should be no surprise that the local political scene has once again undermined the South African rand, leading it to a 1.1% decline thus far this morning. Pulling a page from the Bernie Sanders platform, President Zuma is apparently set to announce free higher education for all in what will be another blow to an already fragile fiscal situation. It seems to me that if Zuma continues on course, he will be able to push South Africa’s debt ratings to B- before he’s done. And the investor community will continue to sell ZAR denominated equities and bonds, along with the ZAR. Be careful in this one. But away from the rand’s demise, while most EMG currencies are softer, the movements have been well within normal trading ranges and don’t appear to point to significant changes in sentiment. However, if the risk-off meme starts to gain traction this week, look for this entire bloc to come under significantly increased pressure.

There is much more data this week on which to focus as well as a plethora of Fed speakers to hear, so while I think December is a done deal for the Fed, perhaps we can learn more about their views for 2018.

Today:

Monthly Budget Statement -$58.0B

Tuesday:

NFIB Small Business Optimism 104.0

PPI 0.1%

-ex food & energy 0.2%

Wednesday:

CPI 0.1% (2.0% Y/Y)

-ex food & energy 0.2% (1.7% Y/Y)

Empire Manufacturing 25.0

Retail Sales 0.0%

-ex autos 0.2%

-control group 0.3%

Business Inventories 0.0%

Thursday:

Initial Claims 235K

Philly Fed 24.1

IP 0.5%

Capacity Utilization 76.3%

Friday:

Housing Starts 1190K

Building Permits 1250K

Leading Indicators 0.5%

On top of all that we have nine Fed speakers on the slate for this week, some of them several times, and it includes Ms Yellen (along with Draghi, Carney and Kuroda at an ECB event) on Tuesday evening. So by the end of the week, we should have an even better understanding of the economy along with Fed views on the next steps. While the market has finally accepted the December move by the Fed, it remains skeptical of next year’s activity. I have a feeling that new Fed Chair, Jerome Powell, is going to be a bit more hawkish than the market currently expects and that over time we will see further upward pressure on US rates, a flatter if not inverted US yield curve, and a stronger dollar on a broad basis. But today, I imagine we have seen the bulk of the movement already, and anticipate a relatively quiet session. The one caveat here is if the equity market starts to show further cracks, we could see a bit more risk-off dollar buying.